There are vast opportunities and risks associated with emerging market bonds.
Emerging market bonds can be attractive to investors. They tend to come with faster growth rates, better returns, and greater diversification.
As rewarding as investing in emerging markets can be, however, it’s important to be aware of the risks involved in taking your money to up-and-coming markets.
What follows are tips that alert you to the risks to watch out for when you invest in emerging market bonds.
Be aware of non-standard distributions
When you buy US bonds, you deal with a system that produces a pattern of normal distributions. For this reason, you can use financial models to make meaningful economic forecasts about the curves that equity prices follow.
It isn’t possible to use such analysis to value emerging market bonds, however. The fact that emerging markets constantly undergo change means that it can be difficult to apply past records to decide how specific events are likely to affect returns in the future.
Loose restrictions on insider trading
While most countries do have laws prohibiting insider trading, few countries are as serious as the US about enforcing those laws. When insider trading is allowed to happen, it can make it difficult for equity prices to accurately reflect the value of companies.
Market manipulation is possible in such an environment, and honest investors can find it hard to compete with investors who are privy to inside information.
Emerging market bonds can be hard to sell
You may do your homework and invest in the best emerging market bond funds you can find. When you need to cash out, however, you may find that your investment isn’t very liquid.
The fact that it’s hard to convert emerging market investments into cash usually means that you end up paying high broker fees in order to sell. Brokers need to work harder to find counterparties, after all. It’s important to take liquidity into consideration when you think about emerging market bonds.
Corporate governance that is of questionable quality
In countries that are economically developed, shareholders have a great deal of control over the way corporations are managed.
In countries with incompletely evolved systems of corporate governance, however, company management or even the government may have greater say than shareholders in the way companies are managed. Poor corporate governance usually correlates with poor returns.
There is greater risk of bankruptcy
Companies in emerging markets often function under weak government oversight. Audit requirements tend to be lax, and there tend to be fewer checks and balances in place.
In addition, since businesses in emerging markets tend to be viewed as risky, they often need to pay higher levels of interest in order to secure funding.
These interest rates place additional burdens on them, increasing the probability that they will fail. When these businesses fail or are exposed, investments in them tend to drop in value.
There tends to be inadequate political stability
Developed countries tend to allow free markets to function with little government interference.
Emerging markets, on the other hand, tend to struggle with government disruptions, an unpredictable taxation environment, unannounced policy changes, uncertain subsidization policies, weak inflation controls, and weak laws controlling resource extraction.
Political instability can sometimes also result in labor unrest and war. It can be hard to predict if investing in even the best emerging market bond funds will end up being profitable.
Whether you’re looking for bonds, bond funds or ETFs to buy, dealing with emerging markets can be rewarding when things go according to plan.
It’s important to realize, however, that with a higher level of reward, comes a higher level of risk. If you wish to invest in emerging markets, the first thing that you need to do is to find investments that allow you to avoid the risks as far as possible.
Finding mature companies to invest in, ones that directly compete with businesses overseas, for instance, can help you be reasonably certain of sound business practices. It’s always important to remember that you need to perform due diligence when you deal with investments in emerging markets.
When you find such corporations to invest in, you are likely to see excellent returns on your investment.
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